Tag: Inflation

Interesting Opportunity in “Series i bonds” – Government Rates Greater than 7%

Reading Time: 2 minutes

The WSJ wrote back in May 2021 of the “The Safe, High-Return Trade Hiding in Plain Sight“, which discussed Series I bonds.

Series I bonds are 30-year US treasury bonds that earns fixed interest with an adjustment to the rate to account for inflation (changes in CPI-U, semi-annually). However, they differ from TIPS in many ways. They are not marketable, they have a limit of $10,000 per person per calendar year, and taxes are due at maturity vs. on an ongoing basis. Oh, and Series I bonds interest rates cannot go below zero, unlike for TIPS. You have to buy them on an ancient looking website, though I will say the security guards looked up-to-date.

However, one issue for Series I bonds is the rate can go down if inflation cools. Right now, the “fixed” portion of interest is literally zero. So the interest is 100% made up of the inflation measures in CPI. So if CPI goes to 0%, there is potential the rate is 0%.

And if you redeem within the first 5 years, you lose the last 3 months of interest. So if you are like me, and think inflation statistics will move lower over time, then the rate you earn in a couple years may not be satisfactory.

At the time of writing, the WSJ wrote:

However, now the Series I bonds rate is much higher:

So if you held for 1 year, now the rate you’d earn would be more like 5.34%. Yes, that is “the catch”. But that is for a US government security! Literally no default risk. By comparison, look at the median corporate bond yields from 1 year+

In addition, while you can only invest $10,000 per person per year, we’re close to the end of the year, so I can stuff an extra $10,000 in there early next year. And my wife can do it. Kids can do it.


Normally I don’t think I’d write much about an “opportunity” like this but it definitely is interesting. If you’re one that thinks inflation will spin out of control, you probably are in some other “hedge” investment, but I like this as a modest hedge (though I will likely cash out early).

Personally, while I want to say I can constantly find equities that will beat this hurdle, it doesn’t seem terrible to me to have some portion of the portfolio in these I bonds. This certainly beats my cost of debt threshold on my mortgage!

Contrarian Corner: Inflation is a Consensus Bet. Look at Deflation $TLT

Reading Time: 5 minutes

I’m thinking of starting a new segment called, “Contrarian Corner.” In these posts, I will try to point out the other side of a company perception, trade, or view that I see as pervasive in the market.

When everyone crowds to one side of the boat, there are typically better opportunities to sit on the other side.

Right now, it seems “inflation is coming” is a pretty consistent view. (Somehow, the people shouting inflation think they are contrarian?) Every report, article, or tweet is talking about it…. I really try to avoid macro talk, but this is too good to pass up.


My favorite example of this is pointing to lumber prices as an indicator of runaway inflation.  This totally ignores prior supply / demand dynamics that led to this surge. To me, its picking a data point to support a view.

I follow lumber prices, so I know why they are up. Canadian lumber is high-cost supply. The crash in prices in 2018 meant many mills to the north were unprofitable and were curtailed. Add in forest fires and impact from the Pine Beetle and supply was constrained. Lastly, Canada implemented caribou protection which curtailed logging activity. Lumber prices were still very low so even mills in the US shut. Now that housing has come back strong, this caught supply off guard and prices surged.

Is that inflation? Or is that a short-term supply demand imbalance? Prices are now at a level where everyone can make money if they can get supply back online. Would you make a bet with me that lumber prices will be higher than where they are right now in 3 years?

There are other examples of this. I’ve discussed oil (prices are up and rig count is at multi-year lows) as well as housing (underinvested post-GFC), and used car prices. Each of these are specific  supply / demand issues or the bullwhip effect.

Is that persistent inflation? Is a one time rise in prices due to a demand shock (COVID lockdown), that resulted in a supply shock, inflation?

The reason why *persistent* inflation matters is because that is what is going to move long-term interest rates.


So Why Deflation vs. Inflation?

First, its that the government’s use of debt to stimulate is suffering from declining marginal returns. Second, its that M2 is NOT what drives inflation. Its also velocity, which continues to decline.

As the National Bureau of Economic Research stated in a 2010 study (my emphasis added):

The median growth of the 20 advanced nations in this study fell by half as their debt levels moved from less than 30 percent of GDP to 90 percent or more. The drop-off was particularly significant at the 90 percent threshold: between 60 and 90 percent of GDP, median growth was still 2.8 percent; above 90 percent it was 1.9 percent. The drop in average growth between countries with debt ratios of 60-90 percent of GDP, and those above 90 percent of GDP, was even greater: 3.4 percent to 1.7 percent

What happens when you go from 100% to 120%? Japan is approaching 200% debt to GDP and we all know the impacts there (their central bank also straight up buys equity ETFs)

Essentially, the marginal benefit we  get from adding a new dollar of debt is going down. And has been for quite some time.

Yes, the coronavirus stimulus was big. But a lot of it also went to plug a big hole in the economy.

We had stimulus checks. That put money directly in the pocket of consumers, but it didn’t create a new income stream for them. Wages didn’t go up and in my view and so the spending will be a 1x boost in some select sectors. Unless all the debt we just used goes to create a new income streams, all we’re doing is exchanging current consumption for future consumption.


Velocity of money is going down.

I’m going to let Dr. Lacy Hunt explain the next bit. For context, he’s a manager on Hoisington bond fund and has been right on bonds for about 40 years (i.e. he’s been long duration). I highly recommend his investor letters. All of these are quotes from his Q1’2020 letter, with my emphasis added:

  • When the Fed buys government or agency securities from the banks, holdings of government debt declines and the banks’ holdings of deposits or reserves at the Fed go up.
  • The bank balance sheet is unchanged except that the banks are selling government paper of longer maturity and they receive an overnight asset at the Fed. Those deposits do not circulate freely within the economy. (Diligent Dollar Note: QE is not just printing money)
  • If the Fed’s purchase of the debt is from non-bank entities, there will be a transitory rise in M2. Further M2 expansion from that new level will depend on the banking industry. The banks high level of reserves at the Fed will result in no further increase in money unless they and their customers make the collective decision for new bank loans to be originated and the loans are used to expand economic output
  • This is what happened in 2010-11. M2 surged transitorily to a nearly 12% rate of growth along with an increase in loans. The money and loans were used to shore up financial conditions rather than channeled into the purchase of new goods and services. As such, the velocity of money fell dramatically, and the Fed’s purchases of securities did not lead to increased economic growth and inflation. After financial conditions were stabilized, the depository institutions held large amounts of excess reserves.

I feel like the first two bullets need re-emphasizing, because a lot of people associate QE with money printing. Joe Weisenthal put it (again, my emphasis added):

When the Fed buys a Treasury, what it’s really doing is replacing one kind of government liability (maybe a 10-year Treasury) with another kind of government liability (an overnight reserve held at the Fed). If you’re a bank that sold a Treasury to the Fed, you’ve given a long-term asset that yields something for a short-term asset that yields something else. No new money has entered the system. The government doesn’t have any less debt. All that’s happened is that the consolidated government balance sheet (the Treasury and Fed combined) has shortened the term structure of its liabilities. After the Fed buys a Treasury there’s less long-term debt outstanding and more short-term debt outstanding. That’s it.

Bottom line: in order to actually get a boost to GDP and inflation, you need the velocity of money to go up.

All these headlines of GDP growth in 2021 tend to be missing the point. If we have 8% growth in GDP following a year where GDP was down 3.5%, then you just have 2% growth on a 2-year basis. That’s not that great considering all the debt taken on. And then you actually need the banks to lend out the capital, but that depends on risk they see in the market, returns, and whether people need the capital for investment.

Add in worsening demographics (and I think its possible we are sitting where Japan and Europe are sitting 5 years from now.

I think what will happen is inflation expectations will continue to rise short-term as the economy re-opens and we have some supply constraints that gives further pseudo-inflation scares, but long-term the writing will be on the wall.

So bottom line: Do I think reflation will happen? Yes. We will be lapping a serious decline in our economy and there are supply constraints. Do I think those supply constraints will be overcome? Yes. And therefore, I think we will continue on the longer-term deflation trend.

How do interest rates affect stocks? A DCF-based impact analysis

Reading Time: 3 minutes

When rates have risen in the past, that has been bad for stocks. Some say rising interest rates affect stocks because you need to increase the discount rate on stocks and that will drive prices lower.

It makes some sense. If investments are competing for my next dollar,  it is true that treasuries at 3% look a lot better than <1%.

10yr treasury.png

 


I have already argued that I am bearish on the notion that interest rates will rise much further from here.

I have based that on (i) real long-term interest rates are lower than people probably think, but are skewed by the high rates of 80s & 90s, (ii) demographic headwinds (baby boomers aging will roll into lower risk securities), (iii) technological improvements are a large deflationary headwind, which will keep rates in check, and (iv) global interest rates remain very low compared to the US and the US is the best house in a bad neighborhood, which will drive increased demand for US$. A strengthening dollar also puts downward pressure on inflation.

I also argued that the Fed has little impact on long-term rates actually (and check that with Aswath Damodaran writings on the subject as well)


Given rates moved up quickly from their lows to ~3.2%, I wanted to show interest rates affect on stocks using a hypothetical company. 

I have made these numbers up, but used average S&P EBITDA and EBIT margins for my starting assumptions, assumed a 25% incremental margin, and a 27% tax rate. I also assumed capex = depreciation as this example is a mature business and growing only at about GDP (3%).

Here’s a summary below of where it is currently trading and model:

mini model

As shown, the company is currently trading around 12x LTM EBITDA (average S&P company trades for 12.5x LTM). Let’s see if this particularly equity looks cheap based on a DCF. I use both the terminal multiple method and the perpetual growth method below.

DCFs

As you can see, the implied prices I get are right around the stock’s price today meaning the stock is trading for fair value. What’s the downside if interest rates go up 1%?

Well first, we need to access the impact on our weighted average cost of capital, or WACC. I assume the risk free rate is 3%, as it is today, the beta of this stock is 1.1, and the equity risk premium is ~5%, in-line with long-term history. I also assume the cost of debt is ~5.5%. It is important to remember that many company’s have fixed and floating rate debt.

As such, a 1% increase in the 10 year won’t actually impact a company with fixed rate debt until they need to reprice it. But for conservatism, I assume it is a direct increase in their cost of debt. Bottom line: I increase the WACC by 1%.

WACC

So how does this translate into our company? Well, as seen below in the bottom right box, a 1% increase in the discount rate would have a ~5% impact on our stock value, all things being equal.

DCF Valuation

Bottom line: Interest rates really have not moved to 4% and so I am skeptical of the 10% correction in stocks today and the increase in rates thus far actually impairing their prospects. Rising rates simply do not affect stocks this much. 

3 (often forgotten) things to remember when investing in Emerging Markets

Reading Time: 6 minutesI wanted to take some time to discuss 3 things when investing in Emerging Markets that are not widely discussed. The impetus for this article was driven by my blog post titled, “How to invest when inflation picks up“, in which I said that because I was bullish on commodity prices, I was going long Brazil.

Brazil has a very commodity driven economy (oil, metals & mining, agriculture) and my view was that a rebound in commodity prices would result in Brazil’s economy improving and its stock market should improve as well.

That call has not come to fruition yet, as shown by the Brazil ETF EWZ being down 21% since that call. And here are 3 lessons I think are important when investing in emerging markets, of which the first will relate to why my call on Brazil has been wrong so far.

1. Changes in currency can have a big impact on results

I would say a central reason why my call on Brazil has been wrong is because of currency.

The Real (Brazil’s currency) has been very volatile and has depreciated against the dollar since the slowdown in China started to occur in 2015 along with the commodity bust, which put Brazil in a deep recession. Recently, a trucker strike derailed plans to get the economy back on the path to recovery and sent the currency tumbling again.

BRL depreciation

What this has meant for my dollar investment is also depreciation…

Let’s use an example to see why: say a stock in Brazil was trading for 100 BRL when the USD/BRL rate was at 3.00. I place an $10,000 order, exchaning my dollars for 30,000 BRL and buy 300 shares. In local currency terms, lets say the stock goes up 10%, such that the quoted price is 110 BRL. I should have made $1,000 bucks on my investment, right?

Nope. If the BRL depreciated like it did in the chart above from 3.00 to 3.85, I’d be sitting on a pretty poor return actually, as shown below.

BRL Investment Example

Alas, this would mean even though I was right on stock selection, the currency movements negatively impacted my returns. This is partially why with all the global currency volatility, currency hedged ETFs are launching all over.

When in investing in emerging markets, currency will be key.

Do I advocate for currency hedges? Sometimes. It depends on the time-horizon. A long term investor may look at the levels of the BRL to the USD and see this as a buying opportunity and therefore, you can be right on stock selection AND the currency may be in your favor which would boost returns.

However, I don’t think anyway can really tell me where a currency will be in 10 years, so I won’t opine on that. What I will say is that our return thresholds should be much higher when investing in Brazil than lets say the US or another developed economy like Germany.

I don’t know what the currency will do over the next 2-3 years, but what I do know is that the real will depreciate over time relative to the dollar. No one questions that the inflation rate in Brazil will be higher than the US over the long run and that should mean that over time, the real should depreciate relative to the USD.

In sum, you have to be aware of currency, especially volatile ones. You’re taking a risk, so we should get paid for that.

2. Just because you’re buying a company’s stock, it does not mean you are afforded the same protections as the US.

Alibaba’s stock is up 25% in the past year and has roughly doubled since IPO’ing in 2014.

But did you know that if you hold BABA which trades on the NYSE, you actually don’t own Alibaba at all?

China forbids foreign investors from owning certain types of companies. As such, you aren’t really buying Alibaba. You are buying a holding company that has a claim on Chinese subsidiaries profits, but no economic interest. The risk here is that China comes in and says that is not allowed and guess what? You own nothing.

The New York Times reported on how China has not actually weighed in on this. You may also want to check out the risk factors of Alibaba’s 10-k entitled, “If the PRC government deems that the contractual arrangements in relation to our variable interest entities do not comply with PRC governmental restrictions on foreign investment, or if these regulations or the interpretation of existing regulations changes in the future, we could be subject to penalties or be forced to relinquish our interests in those operations”. 

I don’t mean to pick on BABA here (Tencent, Baidu, JD.com each have this problem as well), but the risk here might be higher than you think. Lots of people would say, “look China is relaxing its command economy and moving more to a free market. They wouldn’t do something like that.”

Rule of law is paramount in the US, but often forgotten when investing in Emerging Markets because people just look at the low P/E ratios.

And to that I say, look at Russia. In the 1990’s, following the “end” of the Cold War, Russia issued privatization vouchers that allowed investors to actually own former State Owned Enterprises. This was a huge step for Russia and it seemed like the old communist power would be relaxing its grip on businesses. But I encourage you to study what happened when Russia deemed it needed to re-control “strategic sectors”. Yuko Oil Company is a fascinating case study.

In a very brief summary, Yuko went to the private markets and quickly adopted transparent rules and practices, became one of the world’s largest non-state owned oil companies, and even had 5 Americans on its board. The company was paying dividends and growing internationally as well.

When Putin came to power, things quickly changed. The CEO of Yukos was arrested for tax evasion and fraud and Yukos was slapped with a $27 billion fine which was higher than its total revenues for the past 2 years. Yukos was forced to break up and its shares were frozen (to prevent a foreign company like Exxon from buying them). Eventually, Yukos declared bankruptcy. Many viewed this as a direct attack on the CEO of Yukos who was gaining political power.

In sum, I think its important to remember these risk factors and not get too comfortable in international / emerging markets that are known to have limited privileges to foreign investors.

3. Active management makes sense in Emerging Markets

So much has been written on active vs. passive investing in the US, it is actually making me nauseous. But I think this is a good topic to end on for this post, because it sums up the previous points here.

An active manager can weigh the impact of currency on a potential investment. They can weigh the political changes that are happening in the base of a country. And lastly, they are paid to do work on changes in the tastes of the economy.

One area of research I always try to look for is primary work. That is, if I buy the stock of a company, particularly one oriented to consumers, I want to conduct surveys on what its consumer say about the actual product and understand if that helps or hurts the investment decision in any way.

It’s also important to remember that sometimes we take for granted the tidal shift occurring in the U.S. such as Amazon, Netflix, or Apple because we interact with those products and see them on TV everyday. But how can you tell what type of products they are using in India or China without being there? Did you know Netflix and Apple are not the primary sources of products in those countries? They have their own.

Tastes change and they change quickly, so in my view, unless you’re traveling to the country often, you are paying an active manager to do that work. Indexes are backward looking (i.e. they weight the companies that have performed the best in the past at the top in a market cap weighted index), so they do not always calculate the risks mentioned herein. Sometimes they don’t include the entire universe, which can limit returns or at least potential for higher returns.

And as a result, we can see in the chart below that it pays to pay the higher management fee for active. This chart (taken from AllianceBernstein) shows that “70% of active managers in emerging equities have beaten the benchmark over the five-year period ended March 31, 2017, while 66% have outperformed over 10 years, net of fees. On a rolling five-year basis, the percent of active managers outperforming the EM index has never fallen below 50%”.

Active managers in EM

Hope this was helpful for investing in Emerging Markets.

Ray Dalio’s All Weather Portfolio and the place for fixed income in the portfolio

Reading Time: 4 minutesAfter reading Principles, by Ray Dalio, this past winter (which I highly recommend as it gave me many, many things to think about) I have been reconsidering my position on being highly underweight fixed income. Perhaps you are similar to me and kept waiting for rates to move up for an attractive entry point. Ray Dalio’s All Weather portfolio is something to consider.

Now the ten year treasury is hovering around 3% and as I noted previously, is not that far off from long-term averages. Does it make sense to allocate more of our portfolios to fixed income now?

Perhaps you have heard of Ray Dalio’s “All Weather Portfolio” in which he allocates a surprising amount to fixed income, as shown below. His rationale centers on a few factors. One is that by having weighting your portfolio at 80% stocks / 20% bonds is actually heavily weighting “risk”, given the volatility of stocks vs. bonds and for someone like Ray Dalio who is trying to build wealth over the long, long term, performing well in down markets matters.

Bonds should go up when stocks go down due to “flight to quality” impact in a down market. The allocation to gold and commodities provides extra diversification, plus these assets perform well during periods of high inflation, whereas bonds will not perform well.

  • 40% long-term bonds
  • 15% intermediate-term bonds
  • 30% stocks
  • 7.5% gold
  • 7.5% commodities

“The principles behind All Weather Portfolio relate to answering a deceptively straight-forward question explored by Ray with co-Chief Investment Officer Bob Prince and other early colleagues at Bridgewater – what kind of investment portfolio would you hold
that would perform well across all environments, be it a devaluation or something completely different?”

The results are pretty surprising. Dalio says he’s back-tested the portfolio from the great depression, to the Weimar Republic when hyperinflation set into Germany. If you choose not to read Principles, then I implore you to read the white paper on Bridgewater’s website on the background of the strategy.

Using portfoliovisualizer.com, I decided to see the results for myself and ran different 3 portfolio cases from 1978-2017.

The first is based on Dalio’s All Weather Portfolio, though admittedly, I had to do a 15% allocation to gold as a general commodities fund was not available that far back. I then ran a 60% stocks / 40% intermediate treasuries portfolio and then an 80% stocks / 20% intermediate treasuries portfolio.

Let me first say that it shouldn’t be too surprising that the higher stock portfolio wins out. Stocks have been a terrific asset class over this time period. Its higher risk, so higher return makes sense.

But look at the results of portfolio 1, the All Weather Portfolio. Results over this time period are not too shabby, logging a 9.4% CAGR and growing $10K to $380K. But the really interesting thing to me is the worst year and worst drawdown. The worst year was only down ~4%! Compare that to the stock heavy portfolio of -25% and having a near 40% loss in portfolio value during the year. Makes me think of “Slow and steady wins the race”

PV All WeatherPV ALl Weather Chart

This analysis isn’t perfect for a host of reasons. Bonds have been in a bull market for 30 years and were at much higher rates during this time period and subsequently went way down. I do like a quote from the white paper though, in which it states,

“In the US after peaking above 15% in the 1980s, cash rates are now zero. Stocks and bonds price relative to and in excess of cash rates. A 10-year bond yield of 2% is low relative to history but high relative to 0% cash rates. What is unusual about the recent environment is the price of cash, not the pricing of assets relative to cash.”

For further analysis on portfolio outcomes that aren’t tied to back testing, I decided to build a monte carlo spreadsheet analyzing a 50/50 portfolio of stocks and bonds. I then ran 10 random simulations over 40 years to see where the portfolios would shake out. This was pretty simple analysis and I probably should’ve added a component that says, “if stocks are down, then bonds are flat or up”, but decided to keep it random.

Given how high the standard deviation is for bonds, it is no surprise that the highest returning situations are driven by bonds outperforming, but we should also not ignore the simulations where in year 38 out of 40, stocks fall 45%, as shown in scenario 3. Bond provide decent offset to a devastating scenario.

Monte Carlo assumptions

Monte Carlo

I think the takeaway I have is that bonds / fixed income can make sense in the portfolio, depending on what you buy. So far, all I’ve shown is buying treasuries, but think there are solid opportunities in high yield and municipal bonds which are much more stable than stocks, but provide good returns.

I’ll follow up in another article on a bond fund that I think makes a lot of sense to buy for a pretty attractive return.

-DD